SEC charges Goldman Sachs over packaging of subprime mortgage deal

As a security guard looks on, people enter the Goldman Sachs headquarters in New York on Friday. The government has accused Goldman Sachs of defrauding investors by failing to disclose conflicts of interest in mortgage investments it sold as the housing market was faltering.

Diane Bondareff/AP

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Securities regulators charged Goldman Sachs with fraud Friday, in a case that could hold Wall Street's most prominent firm legally accountable in the collapse of subprime-mortgage investments.

The Securities and Exchange Commission charged the firm and one of its vice presidents with failing to disclosure key information to investors in one supbrime-mortgage deal.

Specifically, the SEC says that Goldman failed to tell investors that it had allowed a hedge fund that was betting against the housing market to help structure the portfolio.

The civil lawsuit focuses on a single allegation, rather than a broader case against Goldman's mortgage-product activities. But it amplifies a long-running debate regarding the financial crisis: Did illegal and fraudulent activities on Wall Street play a big role in causing the crisis?

Many financial experts say that the main roots of the crisis lie elsewhere -- including in behavior that was reckless and greedy but not illegal. But federal investigators implied that more lawsuits could come.

"The SEC continues to investigate the practices of investment banks and others involved in the securitization of complex financial products tied to the US housing market as it was beginning to show signs of distress," said Kenneth Lench, chief of the agency's unit focused on so-called "structured products," in a statement accompanying the charges.Goldman's stock fell about 12 percent Friday, while an index of financial stocks was down 3 percent.

Some industry analysts say that the sharp reaction in lower share values reflects the possibility that legal troubles will reach deeper at Goldman and throughout the industry. "I think this is going to be the first of many" cases involving US banks and the crisis, Matt McCormick, a banking analyst at Bahl & Gaynor, said on CNBC.

Goldman, America's largest investment bank, issued a statement saying it would "vigorously contest [the charges] and defend the firm and its reputation."

Short seller influenced collateralized debt obligation, SEC charges

The case in question involves a Goldman client, the big hedge fund run by investor John Paulson. The SEC alleges that in 2007, as a bubble in US housing markets was showing signs of weakness, the hedge fund "paid Goldman Sachs to structure a transaction in which Paulson & Co. could take short positions against mortgage securities chosen by Paulson & Co. based on a belief that the securities would experience credit events."

In other words, the design of this investment product was influenced by someone betting against its success (a "short seller," in Wall Street jargon), and other investors in the product were not told.

The SEC charges that Fabrice Tourre, a Goldman vice president, failed to disclose Paulson & Co.'s role to other investors. The product was a collateralized debt obligation (CDO), a multilevel complex of debts tied to underlying loans including subprime mortgages.

Such CDOs played an important role in the housing boom and bust. During the boom, investor appetite for these seemingly attractive products helped feed the supply of credit to borrowers with poor prospects of repaying their loans. Then, as the risks of subprime loans began to emerge, the implosion in CDO values became a source of financial-industry instability. What had been a key source of credit in the economy quickly dried up.

News reports have documented how both Goldman Sachs and John Paulson made a great deal of money betting on a housing collapse at the right time, after the market peaked in 2006. Neither party faces charges of wrongdoing in those wider profits. And the SEC filed no charges against Paulson or his fund Friday.

The outcome of the SEC lawsuit remains to be seen, but the charge puts at least a dent in Goldman's reputation while the case is hashed out. The firm has also been tarnished recently by criticism that it helped Greece to hide the extent of its national debts.

Political fallout

Friday's charges also come at an important moment politically for the financial industry. President Obama is pushing for new regulation of Wall Street to prevent another financial crisis.

"We can't allow history to repeat itself," Obama said Friday. He didn't mention the SEC action against Goldman, but called for reforms so that taxpayers wouldn't be on the hook for "risky speculators on Wall Street."

In a 2007 e-mail cited by the SEC, Mr. Tourre appeared to talk openly about the risks that were rife at the time. "The whole building is about to collapse anytime now," he saids, citing "more and more leverage in the system."

Meanwhile, the SEC is also fighting to defend its own reputation as a vigilant regulator.

The agency released a report by its own inspector general Friday concluding that the SEC knew since 1997 that R. Allen Stanford probably was operating a Ponzi scheme. The report attributed the failure (until recently) to prosecute Stanford to a managerial culture that was wary of taking on complex cases.